key term - Reserve Requirements

Definition

Reserve requirements refer to the amount of cash that banks must hold in reserve against deposits made by their customers. This policy, set by the Federal Reserve System, is a key tool used to control the money supply and influence economic activity.

5 Must Know Facts For Your Next Test

1. The Federal Reserve sets the reserve requirement ratio, which determines the minimum amount of reserves banks must hold against their deposits.
2. Increasing the reserve requirement ratio reduces the money supply by forcing banks to hold more of their deposits in reserves, limiting their ability to lend.
3. Decreasing the reserve requirement ratio increases the money supply by allowing banks to lend out a larger portion of their deposits.
4. Reserve requirements are used by the Federal Reserve as a tool to implement monetary policy and influence economic conditions, such as inflation and employment.
5. The money multiplier effect, which determines the impact of changes in the monetary base on the total money supply, is directly affected by the reserve requirement ratio.

Review Questions

• Explain how reserve requirements are used by the Federal Reserve to control the money supply and influence economic activity.
  • The Federal Reserve sets the reserve requirement ratio, which determines the minimum amount of deposits that banks must hold in reserves. By adjusting the reserve requirement ratio, the Federal Reserve can influence the ability of banks to lend out their deposits, thereby controlling the money supply. Increasing the reserve requirement ratio reduces the money supply by forcing banks to hold more of their deposits in reserves, limiting their ability to lend. Conversely, decreasing the reserve requirement ratio increases the money supply by allowing banks to lend out a larger portion of their deposits. This tool is used by the Federal Reserve as part of its monetary policy to achieve economic objectives, such as controlling inflation and promoting employment.
• Describe the relationship between reserve requirements and the money multiplier effect.
  • The reserve requirement ratio is a key factor in the money multiplier effect, which determines the impact of changes in the monetary base on the total money supply. When the reserve requirement ratio is higher, banks must hold a larger portion of their deposits as reserves, reducing the amount they can lend out. This lower lending capacity leads to a smaller money multiplier effect, where a given change in the monetary base results in a smaller change in the total money supply. Conversely, when the reserve requirement ratio is lower, banks can lend out a larger portion of their deposits, leading to a higher money multiplier effect and a greater impact on the total money supply from changes in the monetary base. The Federal Reserve uses adjustments to the reserve requirement ratio as a tool to influence the money multiplier and, ultimately, the overall money supply in the economy.
• Analyze how changes in reserve requirements can be used by the Federal Reserve to achieve its economic policy objectives, such as controlling inflation or promoting employment.
  • The Federal Reserve's ability to adjust reserve requirements is a powerful tool for implementing monetary policy and achieving its economic objectives. By increasing the reserve requirement ratio, the Federal Reserve can reduce the money supply, making it more difficult for banks to lend and create new money. This tightening of monetary policy can help to slow down economic growth and control inflationary pressures in the economy. Conversely, decreasing the reserve requirement ratio expands the money supply by allowing banks to lend out a larger portion of their deposits, which can stimulate economic activity and promote employment. The Federal Reserve carefully monitors economic conditions and adjusts the reserve requirement ratio as needed to maintain price stability, full employment, and sustainable economic growth. This flexibility in using reserve requirements as a policy lever is a key aspect of the Federal Reserve's role in managing the overall health of the US economy.

Related terms

Fractional Reserve Banking:

A banking system where banks are only required to hold a fraction of their deposits as reserves, allowing them to lend out the remaining portion and create new money.

Monetary Policy:

The actions taken by a central bank, such as the Federal Reserve, to influence the money supply and interest rates in order to achieve economic objectives.

Money Multiplier: The process by which a change in the monetary base leads to a larger change in the total money supply, based on the reserve requirement ratio.